Portfolio Protection: Stocks Are High and Options are Low

In 2013, the stock market has enjoyed a huge rally with the lowest volatility in years. The S&P 500 Index (INDEXSP:.INX) is set to gain 28% this year, the best return since 1995, and has now risen 170% off the 2009 low. But equally impressive as those numbers has been the lack of any major, or even minor, pullback:

-During these 4.5 years, there only has been one decline in excess of 20%.
-In the past 4.5 years, there have been only two 10%+ drops.
-In the past 18 months, there was just one 5%+ decline.

These are well below the historical norm and suggest the market is due for a pullback.

In the 70 years spanning 1940-2010, the data shows that every year saw at least one 5% market drawdown. And over half of those years were true market corrections with a 10+ declines:

By these measures, the probability of a measurable decline continues to mount with each month as this bull market continues.

Combine this with fact that implied volatility for index options, as by the VIX (INDEXCBOE:VIX), is pressing not only 52-week lows but is near the low end of its 20-year range, making the case for buying portfolio insurance very compelling.
Marry Me

One of the most basic ways to hedge a long holding against a decline is to engage is to buy puts in what is called married put strategy. This approach limits downside losses but leaves potential gains to the upside unlimited.

The trade-off is the cost of the puts, which can viewed as premium for any type of insurance. The graph below shows the cost of the put premium, and how that can both drag on returns but leave the upside profit potential unlimited.

Also note that any sharp decline is likely to be accompanied by an increase in implied volatility, which would be beneficial to the put protection portion of the portfolio.

Current Cost of Insurance

Let's assume one has a portfolio that in one fashion or another tracks the S&P 500 or the related SPDR Trust (NYSEARCA:SPY) ETF. The cost for a full year of full coverage using at-the-money puts is the lowest since 2006.

To calculate full protection currently levels simply divide the notional value by the underlying contract price, and then apply the 100 multiplier.

So with a theoretical $100,000 portfolio and the SPY currently around $183, that would equate to 546 shares, requiring 5.5 puts. We'll round up to 6 contracts.

This next table assumes one bought the at-the-money LEAPs, with one year remaining until expiration, on December 31 of the prior calendar year. I've adjusted for the number of contracts needed.

It takes going back to 2006, prior to the credit crisis, to find lower-cost portfolio insurance.

Reducing Cost

Given I am fairly constructive on the market and expect positive returns in 2014, I am not eager to spend too much on portfolio insurance.

Wwo ways to reduce the cost of insurance would be:

1) Buy further out-of-the money puts which cost less though they will not offer the same initial level of protection. Think of this as increasing your deductable.
2) Scaling into put protection. For example, it could make sense to buy one-half of the put protection now, and then consider adding a quarter of put protection after each 3%-5% increase in the market over the next six months.

In either approach I'd want to have full protection to protect against anything more than a 5% decline and or protect gains above 6-10% in first half of 2014. For the prudent investor, the price is right.

Steve Smith's OptionSmith portfolio is up 41% in 2013. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.